Thoughts on Economic Policies Proposed in the State of the Union Address

President Barack Obama gives his State of the Union address on Jan. 27, 2010.

What can we say about the economic policy prescriptions proposed by the president in Wednesday night’s state of the union address? Unfortunately, they fail to inspire confidence. The president proposed a new tax credit for small businesses who hire new workers or raise wages, elimination of the capital gains taxes on small business investment, a tax incentive for small and large businesses to invest in new plants and equipment, incentives for infrastructure spending, tax rebates to homeowners for energy efficient remodeling, and an extension of the Bush tax cuts for households earning less than $250,000. He also wants financial reform and a bank tax, a doubling of exports over five years and an education bill that would allow a government takeover of the student loan market. And to look fiscally responsible, he proposed a budget “freeze” for about 17 percent of federal discretionary spending, but then argued it should not start until 2011.

The tax credit for small business is not really new, as similar proposals have been implemented before (e.g., the New Jobs Tax Credit and the Targeted Jobs Tax Credit in the late 1970s). The drawbacks of marginal employment subsidies such as this tax credit are significant. They tend to have a minimal effect in terms of new jobs or increased wages, and are not cost effective (i.e., the cost per new job or raise is high). They are also complex, costly to administer and would require an increase in other taxes or debt, which would create additional distortions. In the best case scenario, the net effect of such a program is likely a small negative to the economy as a whole.

Financial reform is important but unfortunately the current administration seems to have no coordinated objective. A proposal that requires banks to repay taxpayers for financial crisis aid through a special fee is a decent idea if implemented correctly — which does not seem likely given the newfound “populist” bent of the president following Republican Scott Brown’s election to the U.S. Senate in Massachusetts. Any fee on banks should be based on the size of banks as the president proposes; however, it should also be positively related to the illiquidity of the bank’s assets, the amount of short-term debt holdings, and the maturity mismatch of assets and debts. Such a fee should not go directly to the government, to be spent recklessly, but instead should be held by a nongovernmental body for the purpose of providing stability in turbulent times. Thus, this would be like a fee for insurance. Another option is to scrap the fee and just make capital requirements depend on the factors listed above. It is important to understand that the propensity to bail out banks and other institutions is itself a type of free insurance that has decreased the perceived cost of risk taking. However, capital requirements and fee-based insurance mechanisms to increase financial stability are not free of costs.

It is not clear why fees would be imposed on banks but not other financial institutions. Nor is it clear why banks are being charged a fee when they have repaid most of the bailout money, while nonbank entities such as unions and automakers that also received bailout money, which they are unlikely to repay, are not charged the fee. In particular, employee unions (especially for government employees) are creating the next fiscal crisis in America as their lavish benefits are increasingly threatening the solvency of municipalities, cities and states. Richard Lowenstein, in “While America Aged,” details how union pension debts ruined General Motors and are poised to impoverish cities and future taxpayers. Yet unions have not been made out to be bad guys like bankers; instead they are given sweetheart deals in major health care legislation!

Another of Obama’s points was to “end unwarranted taxpayer subsidies” that go to banks for student loans. The government takeover of student loans would limit repayments to 10 percent of annual income and for no longer than for 20 years, which seems reasonable. However, someone who gets a job in government may only have to pay for 10 years. Do we really need more taxpayer subsidies that encourage government employment?

The president also proposed doubling exports over five years. To achieve this, he said we need to “seek new markets aggressively, just as our competitors are.” In addition, he stated that we need to strengthen our trade relations with key nations such as South Korea, Panama and Colombia. Yet, Obama has long opposed trade deals with two of our closest allies: South Korea and Colombia. However, if he can’t even stand up to labor unions to impose a tax on “gold plated” health insurance benefits in the health bill, I doubt he will push for trade deals with South Korea or Colombia anytime soon — labor unions will not allow it. This is unfortunate.

Finally, business tax incentives, tax rebates for housing, expansion of the Bush tax cuts for those making under $250,000 and reckless spending are all similar in nature to the policies of the Bush administration that Obama continually rails against and blames for the current economic crisis. I doubt that these proposals will help to expand economic activity or prevent future crises, while the lack of fiscal responsibility in Washington will increase the probability of a future crisis.

John W. Diamond is the Edward A. and Hermena Hancock Kelly Fellow in Public Finance at the Baker Institute and an adjunct professor of economics at Rice University.